Investors are asking if it’s safe to invest again. Cormac Lucey explains why they might want to hold off for now
“Is it safe?” That was the question asked of Dustin Hoffman in the movie “Marathon Man” as he was being interrogated while strapped into a dentist’s chair by Laurence Olivier (playing the role of an on-the-run Nazi war criminal), expertly reimagining our worst dentist nightmares.
Much like Hoffman’s position, equity markets have become a nightmare. Investors keep asking themselves whether it is safe to invest again or whether this bear market has longer to run.
Jeremy Grantham, the veteran investor, wrote an article on GMO.com in late August warning that the “current super-bubble features an unprecedentedly dangerous mix of cross-asset overvaluation (with bonds, housing, and stocks all critically overpriced and now rapidly losing momentum), commodity shock, and Fed hawkishness.” He concluded that we haven’t yet seen the bottom.
Having pumped vast amounts of liquidity into the world economy to stave off the deflationary effects of the pandemic in 2020, central bankers were shocked by the firm inflationary response. They responded by tightening monetary policy – the usual precursor of recessions.
It’s important to note that this move pre-dated the Russian invasion of Ukraine with its resultant economic disruption, and even more important to note that the conflict in Ukraine has fundamentally changed the rules of the economic game we had become used to.
Zoltan Pozsar of Credit Suisse has written that, in recent decades, “the EU paid euros for cheap Russian gas, the US paid US dollars for cheap Chinese imports, and Russia and China dutifully recycled their earnings into G7 claims.”
The problem is that global supply chains work only in peacetime, “but not when the world is at war,” Pozsar notes.
While Russia is currently being forcibly disentangled from trade with the west, China may decide to voluntarily and slowly remove itself to avoid the shock of aggressive disentanglement should its cold war with Taiwan ever turn hot.
Key monetary indicators remain recessionary. In the US, money supply is growing at a slower pace than inflation, meaning the real quantity of money in the economy is falling. The yield curve has just inverted, meaning short-term (two-year) rates of interest exceed long-term (10-year) rates.
For several decades, this has been an unerringly accurate harbinger of recession. Unfortunately, central banks remain in tightening mode for those wanting equity markets to lift as inflationary pressures prove to be more than just “transitory.” They say, “Don’t fight the Fed” (the Federal Reserve) and with good reason. Caution is warranted.
There are other challenges facing equities. On previous occasions over the last two decades, the depth of downturns has been eased by the fact that not all large economic blocs have been in recession at the same time.
In the wake of the Global Financial Crisis, when the western world was in deep recession, strong growth in China helped ameliorate the global impact of the recession and accelerate its ending. Today, all major economic blocs are simultaneously threatened by recession, which risks making this recession deeper and longer.
What might signal an equity market bottom? I’ll be looking for a combination of value, investor sentiment, and a change in central bank behaviour.
Share prices would need to drop sufficiently to be reasonable value. In 2000 and 2007, this required price drops of the order of 50 percent or greater. Speculative sentiment among investors would need to be replaced by the cold fear that characterises true market bottoms and central banks would need to replace tightening with easing.
A halting of central bank tightening would certainly trigger considerable euphoria. But, having been too slow to tighten, central bankers cannot risk their diminished credibility by taking their feet off the monetary brake before inflationary pressures have been well and truly suppressed.
Remember: the Nasdaq crash kept deepening two decades ago, even after the Fed had started aggressively cutting interest rates.
So, is it safe? I don’t think so.
Cormac Lucey is an economic commentator and lecturer at Chartered Accountants Ireland
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